What are the big, basic things that make economies grow? Economists and politicians can argue about degree and detail—and they surely do—but generally keeping taxes low, competition fierce, and monetary policy tight are seen as the holy trinity of growth economics. Here is how those policies have worked for the past 25 years.
Boosting competition. When companies fiercely compete with one another, the result can be lower prices and more innovative products and services. As McKinsey consultant Diana Farrell puts it, "creating maximum competitive intensity" forces companies to constantly innovate—whether through new technology or business models or management processes—to keep ahead of rivals. And key to competition is keeping government regulation as light as possible while also keeping products safe and preventing harmful monopolies. Starting in the 1970s, many American industries were deregulated, including airlines, trucking, railroads, banking, electricity, and communications. This bipartisan effort, explains JPMorgan economist James Glassman, "has broken down concentrations of market power and unleashed innovation."
In his book The Competition Solution, Paul London, an economic adviser in the Clinton administration, highlights the many ways deregulation and increased competition through global trade have created a more vibrant economy. Established financial institutions such as big New York banks, the New York Stock Exchange, and insurance companies had to compete with junk bond financing, the Nasdaq stock market, and bigger regional banks. Southwest led the challenge to United and American Airlines. And, of course, Wal-Mart challenged locally powerful department and grocery stores. "I think the key to growth is the flexibility you get with deregulation," London says.
Lowering taxes. While the Reagan tax cuts of the early 1980s—dropping the top rate from 70 percent to 28 percent and indexing tax brackets for inflation—get much of the attention by economic historians, don't forget the capital gains tax cut of 1978, authored by Republican William Steiger and signed reluctantly by Jimmy Carter, or the 1997 capital gains tax cut signed by President Clinton. The economic rationale behind lowering tax rates is that high taxes can discourage work, savings, and investment and encourage tax avoidance and evasion.
"Until very recently, there had been a growing bipartisan consensus, acknowledged at least implicitly, that you cannot run a high-tax [economic] regime and be competitive," says Lawrence Lindsey, a former economic adviser to President Bush. Indeed, it's tough to find an economist or politician who advocates a return to 1970 levels of taxation, though they may gripe that tax cuts are infrequently matched by spending cuts, resulting in big budget deficits. As Clinton's Council of Economic Advisors stated in 1994, "It is undeniable that the sharp reduction in taxes in the 1980s was a strong impetus to growth."
A recent paper by David and Christina Romer of the University of California-Berkeley examined U.S. tax cuts since World War II and found that "tax increases appear to have a very large, sustained, and highly significant negative impact on output ... [and] that tax cuts have very large and persistent positive output effects." Now every economist isn't for every tax cut—David Romer himself was against the Bush tax cuts—but as a general guideline, lower taxes seem to be better for economic growth than higher taxes.
Whipping inflation. It's bad enough that rising prices cut purchasing power, but they also distort investment decisions. Individuals and businesses "look for inflation shelters instead of where capital can be most efficiently allocated," Lindsey says. Inflation seemed out of control heading into the 1980s, but economists have now nicknamed the past quarter century "The Great Disinflation." Along with deregulation, tighter monetary policy under Federal Reserve chairmen Paul Volcker and Alan Greenspan saw inflation fall from double-digit rates to 2 percent or so today.
Low inflation and price stability are seen by many economists as essential for long-term growth. "It is important to avoid spikes in inflation that have to be reversed by recessions like the one at the start of the 1980s, so a sound monetary policy is key for growth," explains Martin Feldstein, head of the National Bureau of Economic Research and often mentioned as a potential Fed chairman. "We have, of course, had recessions during these years. But a sound monetary policy that kept inflation low has avoided the deep swings that characterized earlier periods."